Friday, August 29, 2008

Despite the Nobel prizes and the thousands of econometric academic papers, economics remains a pseudo-science anxiously grasping for the lustrous numerical certitude of physics and the hard sciences.

Science is based on supporting a theory of how something works with real-world data drawn from experimentation which can be replicated by others. The theory can then be used to predict real-world interactions (how much electrical energy is required to split water into its constituent hydrogen and oxygen, for instance.)

Economics predicts nothing of the future with any certitude or precision. It is a cliche that economists never correctly predict recession, or indeed any other sea change in the economy.While it may seem harsh or unfair to categorize economics as a pseudo-science, science is clear-cut: can your results be replicated by others? can your results be used to accurately predict real-world interactions? If your results fail these two tests, then you're not doing science.

Economics is a "social science," which is less an expression of science and more an insecurity seeking confirmation ("we have numbers! We have data! We're worthy!") of value in a world dominated by the hard sciences.

Amidst all the nonsense published under the rubric of "post-modernism," the key point remains: the "hidden" structures of one's language, culture, class and era influence one's interpretation of "facts" and "data."

The assembly of "data points" is supposed to be objective, but of course data can be massaged and edited to support one's preselected position or unconscious bias. Data thus becomes manipulative, not enlightening--witness today's announcement that the U.S. GDP grew at a rate of 3.3% in the 2nd quarter.

Hmm. This is quite expansive for a large economy like the U.S., and if this were reported about Japan or the E.U. then the superlatives would be flowing. A 3.3% expansion is just about as good as it gets for a large diversified economy.

Yet those of us who walk or ride bicycles here in one of the most prosperous, wealthy enclaves in the world, home to Silicon Valley, tourist meccas San Francisco and Napa Valley, and a handful of the greatest research universities on the planet (Stanford, UCSF, UC Berkeley) see abundant "data points" in the real world with our own eyes that the economy is in decline.

If economics were truly a science, this kind of dramatic disconnect between "official" macro-statistics and the data gathered in the field would not require some sort of magical reconciliation to make sense.

Hence the inescapable conclusion: economics is a pseudo-science and not to be entrusted with any credibility. It is closer to "political science" in the sense that practitioners weave all sorts of statistical webs that ultimately support what their hidden cultural/academic structures and personal biases have already ordained.

Another similar field is marketing, which also relies on the illusions woven by "hard data." You bought one of the first iPods? Ha, data point! You're an "early adopter," and based on this "hard data" I will now try to sell you a Kindle reader.

The only problem with this data-driven marketing structure is that it no longer works. As I suggest in my new little book, Weblogs & New Media: Marketing in Crisis , the Marketing Emperor truly has no clothing, yet his enthralled and desperate subjects continue to rave about the finery of the lace on his sleeves.

Which brings me to cost structures. Here we enter the thicket of academic structure, which demands that aspirants to the golden glories of tenure write numerous narrow-focus papers which get published and thus "advance" knowledge.

"Big Picture" papers are frowned upon because they are difficult to back up with data. Or even worse, some fundamental trend might not lend itself to "data." If so, academic success requires researchers stay away from such trends or risk academic "death" i.e. denial of tenure.

For instance, when did the U.S. populace and government on all levels trend away from fiscal responsibility? When did borrowing vast sums of money or refinancing to pull out all of one's equity become "the norm" and unworthy of comment? What triggered this convergence of irresponsibility?

If economics cannot shed some light on this fundamental trend, then exactly what good is it?It seems abundantly clear that the cost structure of the U.S. economy has ballooned to unsustainable levels. By cost structure I mean all the fundamental inputs: energy, healthcare, etc.

For instance: the budget of every city, every county, every agency and every department of every government in the U.S. is under pressure from two basic sources: pension costs and the inexorable rise in mandated healthcare employee costs. What was once a relatively modest share of total employee compensation--healthcare insurance, drug coverage, and eye care--has swollen into a huge percentage of total employee compensation.

If you wonder why building permits now cost more, and parking tickets have tripled, and why garbage fees are skyrocketed, look no further than the crushing burden of ever-rising pension and healthcare costs on every level of government.

These skyrocketing costs act as a huge economy-wide tax, raising the input costs of every good and service in every nook and cranny of the economy. Healthcare (what I call "sick-care" because our collective health continues to slide despite ever-larger sums spent on "curing" us) consumes $2.7 trillion of the $14 trillion U.S. economy--almost 20%. That's equivalent to a 20% VAT (value-added tax) on every purchase.

The bubble mentality of the past decade has also constructed an economy-wide tax. Here is an example. A famed local independent bookstore which once had 3 outlets in the SF Bay Area recently closed its last store. The local newspaper reported it owed two months rent of about $6,600.

How many books would the store have to sell to net $3,300 for basic rent? Add in utlities, employee wages and benefits, cash flow needed to maintain inventory, etc. and you come up with a stupendous number of books which would have to be sold.

Compare that to a cost structure in which rent was $500 per month.

Virtually any crummy retail space is asking $2/sq. ft. and up, regardless of how many empty storefronts there already are in the block. A famous local bakery just announced it's closing due to a rent increase. We have to wonder: just how greedy and stupid is the landlord? As the economy sinks into a death spiral, who is going to rent that vacant space?

Though greed undoubtedly plays a part, we should also look at the cost structure of the building. Let's say a commercial building which was once valued at $1 million sold at the bubble top for $3 million. The new owners now have huge built-in costs: sky-high property taxes and a massive mortgage, not to mention their own health insurance is skyrocketing. From the point of view of the owners, he/she needs to raise rents just to keep up with rising costs.

Too bad nobody noticed that small business can no longer afford bubble-era rents.

So how long can these high-cost-structure owners cling on as the recession takes down more and more of their small-business tenants? How can the cost structure be realigned with what the economy can support?

By all high-cost owners going bankrupt and their assets being sold for cash.

Eventually this may well seep into the heavily protected healthcare industry as hospitals, clinics and emergency rooms close due to rising costs.

Correspondent Paul M. recently made this cogent comment:

You are closing in on a health care solution when you write: (Income Inequality in the U.S. August 22, 2008)"I have long suggested that the only real driver for lowering the cost structure of healthcare in the U.S. will be 100+ major state-of-the-art hospitals across the border in Mexico which cater exclusively to Americans with cash, clinics which provide the same level of care for 25%-30% of the cost of the care in the U.S. The choice for U.S. healthcare will then be, adapt or die. Creative destruction is the core of capitalism. Fear-based moat-building and the garrisoning of fiefdoms protected from global competition can only stave off the destructive forces of bloated cost structures and inequality for so long."

Thank you, Paul, for this provocative commentary. If we trace back the high cost of educating doctors in the U.S., we stumble upon the huge student-loan debt many would-be doctors must carry forward. Hmm. Then we notice the $250 textbooks (used, of course--new are slightly higher.) Does it cost more than $20 to print even a thick heavily illustrated volume in Asia? Let's say a fair royalty would be $10 to publisher and author. Is there any justification for a price above $40?

A thorough cost-structure analysis would turn up seemingly endless numbers of these bloated inputs throughout the U.S. economy. Yes, most are "protected" by regulations, tariffs, union contracts and the like.

If we ponder the closure of hospitals and emergency rooms, then we have to wonder: what if the hospital that just closed was bought for $1 by a non-U.S. firm and opened with a much lower cost structure (salaries included)? What if pharmaceuticals were purchased at global market prices? Could the hospital then "afford" to offer care which was paid for in cash, thus dispensing with all the 50% added "overhead" costs of insurance, counterclaims, etc.?

In the current climate and economy, no--that's not allowed. Hence my suggestion that the firm acquire the hospital across the border in Mexico where the forces against lower cost structures are not so thick and well-defended by inertia and moated fiefdoms.

Lower healthcare costs by 80%? "It can't be done!" True--not with the current mindset and cost inputs. But can it be done elsewhere? It already is.

The U.S. economy will only thrive when a bookstore can rent a space for $500 rather than $3,300, and anyone can get basic healthcare and even outpatient operations for a modest amount of cash on the barrelhead. Until the entire cost structure is lowered via insolvency, bankruptcy, the contraction of credit and the tearing down of entrenched fiefdoms, then the inefficiencies and inertia of bubble-era valuations and legacy/fiefdom costs will continue strangling the U.S. economy.

Thursday, August 28, 2008

The Housing Revolution: From Speculative Investment to Low-Cost Shelter The revolution unfolding in U.S. housing will shift the perception of home ownership as a store of investment/speculative value to low-cost shelter. Some will say this is a horrible devolution, others a much-needed evolution; perhaps it is another cycle based on the larger credit-expansion/contraction cycle: (see below)

The key feature of housing as investment or speculation is that it depends totally on cheap, readily available lending to sustain prices. Once cheap, readily borrowed money dries up, so does the pool of potential buyers. When sellers far outnumber buyers, prices fall--and as credit shrinks, then the price eventually falls to its cash value, i.e. what someone is willing to pay in cash for the dwelling.

The salient feature of housing on the upswing half of the cycle is that the entire cost structure becomes bloated. When prices are rising by 10% or more in a short period of time, the cost of labor and materials is sloughed off--the owners' eyes are glued to the prospect of quick profit.Even those who are "investing for the long-term" focus not on rising costs but on the "value added" by unnecessary "improvements" such as granite countertops, lavish bathrooms, "bonus rooms," etc. The perceived "value" is not so much the actual advantages of the improvement--let's face it, granite doesn't make you a better cook or even enable faster cleanup--but on the increase in selling price the improvement is supposed to yield.

In the upswing, "home" magazines proliferate as do articles about "which projects add more value." Housing is perceived as a store of appreciating value, and those who benefit from this perception relentlessly propagandize this perspective in the mainstream media.

As the "land rush" to buy/invest and "add value" increases, so do costs all along the line. Demand for skilled labor and materials trigger hefty increases in the cost of construction and renovation; as builders get busy, they raise their profit margins. As sales prices rise, property taxes increase; all of these rapidly rising expenses of ownership are ignored as prices are climbing even faster.

At the peak of the credit cycle, credit growth is exponential, feeding a speculative frenzy. The costs of ownership far exceed the cost of renting, but "ownership" is no longer the focus; housing is viewed first and foremost as a highly leveraged speculative vehicle that "everyone" can play.As the speculative mania takes hold, builders ignore rising costs and the fundamentals of location and demand, and leverage all available resources into building "product" which can be sold even before the foundation is poured.

Then the credit cycle turns, as it always does, usually suddenly. Highly leveraged credit bets fail, risk rears its ugly head, regulators discover widespread fraud ("round up the usual suspects") and the euphoria is replaced by fear.

As credit dries up, all real estate is faced with plummeting demand. Buyers are scarce for two reasons: few can borrow the vast sums now required to buy property, and potential buyers are wary of falling prices. Buying on the way down ("catching the falling knife") is a good way to lose one's shirt.

The virtuous cycle of ever-rising values supporting ever-rising leverage reverses, and declining prices pull the props out from leveraged speculation. No-down or low-down payment owners quickly sink to negative equity, and even those who put down 20% are facing 50% losses in capital after a mere 10% decline in the value of their home.

As speculators are forced out of the real estate market by losses and insolvency, then players revert to the "real estate is the best long-term investment" mantra.

Unfortunately there is a huge fat diseased fly in the "investment" ointment: the bloated cost structure left from the speculative bubble remains firmly in place. Everyone in the food chain is loathe to lower prices; everyone from contractors to suppliers to cities collecting property taxes has built high-cost structures: extra employees, membership at the YMCA for all employees, new trucks, etc. etc.

And in the go-go environment of easy speculative money, regulatory costs climb as well; with few constraints on costs, then workers compensation insurance, liability insurance, etc. all rise as well, and then stubbornly stay high even as real estate slumps.

As losses mount, everyone in the food chain demands subsidies and give-aways to prop up sagging prices. Since costs have risen far beyond historical measures of value and speculative demand has vanished, the supply/demand ratio cannot support inflated prices without government subsidies.

But alas, as the true (high) costs of such subsidies becomes visible, public support disappears and the subsidies are cut. Once this last leg of support is pulled, the price of real estate falls to its "natural" level, i.e. in line with the value as set by credit availability and by the market-rate rental income the property generates.

Since overbuilding is a natural result of credit bubbles, there are now more residences than households. As credit tightens, the entire economy contracts; as jobs are lost, households increase in size and the demand for more residences drops.

As losses mount and assets deflate, households jettison surplus housing: second homes, "investment" condos, etc., further adding to the inventory of empty homes.

If the credit expansion was truly historic (i.e., 1920s and the present), then the resulting contraction will be historic, too, lasting longer than anyone anticipates.

As housing declines along with credit availability, bottom after bottom is called by the real estate industry--but all are false. As equity shrinks and each "bottom" is followed by further declines, households' perception of the "long-term investment value" of housing weakens.

The problem is the cost-structure of the housing food chain remains completely out of touch with historic ratios. Once the cost structures rise, they stubbornly resist any decline; skilled labor only grudgingly accepts lower pay, counties grudgingly lower property taxes, realtors grudgingly discount fees, and so on.

For instance: back in the early 1980s, my company built numerous small (under 1,000 sq. ft.), modest "starter homes" for about $40,000, or about $45/sq. ft. Adjusted for inflation, such homes would cost about $90,000 in today's dollars, or $90/sq. ft. Yet prices for even modest homes have soared to $200 to $300/sq. ft., and the average size of houses has bloated to absurdly impractical 3-4,000 sq. ft. McMansions.

Note that the cost-structures of maintaining such huge homes have risen, too; heating and cooling such vast interior spaces is not efficient or cheap, and commuting to distant exurban housing is no longer cheap, either.

The ultimate end-point of the credit contraction cycle is the reduction of the entire cost structure of housing back to historic norms: roughly 2 to 3 times median income to own, and roughly 1/3 annual income to rent.

Once the perception of housing as a sure-fire long-term investment has been eroded by year after year of declining or stagnant prices, then households will revert to deciding to buy only if buying is actually cheaper than renting. With leverage largely unavailable ("prove you don't need the money and we'll lend it to you"), the "return on investment" of the cash required to buy a home will be: the fixed costs are lower than renting an equivalent dwelling.

About 25% of all homes in the U.S. are owned free and clear (no mortgage). As elder owners pass on, these houses may well be seen by the lucky offspring/inheritors not as an asset to sell to fund superflous consumption but as a desirable low-cost place to live: that is, shelter.

Sometimes a revolution occurs mostly in the minds of the participants.

Wednesday, August 27, 2008

The Price of Debt-Based "Prosperity": Slow Erosion, Inevitable Decline The sudden demise of Empire into chaos makes for a rousing made-for-TV movie, but empires actually decline in the most tedious fashion. Decades or even hundreds of years pass as debts and profligacy mount, wars sap the will to maintain borders, water/food shortages, famine and pestilence reduce populations and a citizenry desperate for diversion and "answers" turns to circus and dark religious cults.

None of this is surprising to those who study animal populations. When food is short, or a new disease or predator sweeps through, then the population drops dramatically. Eventually, the rains return and food is again plentiful, and the population rises to beyond the carrying capacity of the locale. As food becomes scarce, overcrowding creates tensions and enables new diseases to spread, and various "mental illnesses"/erratic behaviors become common as stress builds. The population crashes/dies off to a level below sustainability and the cycle repeats. (Barring the sudden arrival of a 20-kilometer wide meteor.)

Hmm, sounds like the Anasazi, the Maya, 14th century Europe, etc.

As supplies get tight, then conflicts over the remaining resources arise, and the temptation to "eat your seed corn" i.e. bleed the future to sustain the present becomes ever higher.And on that note, let's take a look at the U.S. National Debt going back to 1940, adjusted for "official" inflation:

1. The huge deficit spending required to fund World War II in the 1940s is but a blip.2. From 1945 to 1980, fully 35 years, the deficit/debt was remarkably stable when adjusted for inflation. I can vividly recall the horror and outrage in the late 1970s when the Federal deficit ran up to the stupendous, fearful sum of $40 billion--about $120 billion in today's money.Now we accept talk of a budget deficit 8 times as large ($1 trillion) with a barely stifled yawn.3. The "cut taxes, borrow and spend" era began in 1981 and has continued to this day, interrupted only briefly by the rising revenues created by the dot-com era circa 1998-2000.4. Remember "the peace dividend"? That was the reduction of U.S. military spending after the Soviet Union collapsed in 1989. In terms of its share of GDP, defense spending dropped quite a bit. But that reduction isn't even visible in this chart, is it? Proving once again that entitlements are driving the budget deficit.5. Regardless of falling military expenditures, the debt has risen in what looks like a "blow-off" similar to the dot-com stocks and the housing bubble just before those manias collapsed. Only this bubble was a borrowing mania, not a speculative mania. Nonetheless, the future of all blow-off peaks is the same: collapse.

Here is a laughably optimistic chart of future entitlement spending. It's laughable because it's based on implausible assumptions with no connection to reality--for instance, that Medicare will grow by 2% per year when in reality it grows at least 6% - 10% per year.

What's interesting about this chart is the interest paid on the debt we will have to take on to fund all these entitlements: notice how the interest dwarfs the actual entitlements spending.

By these absurdly euphoric assumptions--taxes stay steady instead of plummeting in the coming Depression, Medicare barely rises despite the population drawing Medicare benefits doubling, etc.-- we're only in trouble by 2040, when the interest on all this colossal debt rises to 10% of GDP--$1.4 trillion in today's money, or roughly half the entire Federal budget.

If interest rates rise, we won't even have to wait that long for interest to eat up half the budget. As shown on the first chart, a rise in the interest rate back to the 9% - 10% would very quickly cause interest payments to rise in tandem with ballooning deficits to $1 trillion per year or more, effectively squeezing other government spending and private lending for business and mortgages.

Although we seem to have forgotten it, the pool of new capital available to borrow is not endless. Every dollar that is invested in Treasury debt (bonds) is a dollar which is not available to private lending for business expansion or home mortgages.

You think the government budget battles are ugly now--wait til $500 billion more has to be scraped from other spending to pay the exploding interest.

Though readers may well be tired of this chart, I reprint it here to illustrate two key points:1. low interest rates in the U.S. are the result of massive intervention by the Chinese government banks; all the other purported "reasons" are noise2. interest rates run in cycles of 17-24 years, and the U.S. is just beginning a decades-long uptrend in interest rates.

Those who assume interest rates can stay low for decades to come due to deflation are missing the key macro-drivers of interest rates: risk, availablility of capital to borrow, and where that capital comes from: profits and savings.

Many are expecting the Gulf Oil states' sovereign wealth funds (SWFs) to magically save the day by investing trillions in oil profits in the U.S. Nice idea, but the Export Land Model of oil reveals that the amount of oil available to export will be dropping due to exploding domestic consumption, regardless of how much is pumped. Fewer barrels sold means less money in SWFs. And let's not forget that many SWFs have already suffered stupendous losses in their initial "investing" in U.S. debt and financials.

The sheer scale of U.S. deficit spending dwarfs even Gulf State SWFs. All the oil profits available for non-domestic investment are estimated at perhaps $500 billion a year-- about the current size of the U.S. Federal deficit. That means if every single oil-profit dollar flows into Treasuries, a deficit of $1 trillion would require another $500 billion from somewhere else.

As China's economy contracts along with all other global economies, that nation's surplus of dollars will contract, too. Less dollars piling up means less dollars available to soak up the endless flood of Treasuries (i.e. deficit spending).

Astute readers Dr. K. and Craig M. both forwarded this article on how the Chinese are raising dollar reserves "through the back door" by forcing banks to increase capital reserves: Beijing swells dollar reserves through stealth (Telegraph.uk)

These tricks are not sustainable. The game is about up. Regardless of whether the dollar rises or falls, the enormous trade imbalances of the past decade will be resolved by a drying up of surplus dollars. If the U.S. needs $1 trillion to fund its wars and entitlements, and another $1 trillion (or 3) to fund its housing mortgages and business borrowing, there simply won't be enough dollars available to buy all this unimaginably vast new debt.

Recall that money is a commodity. When there is less supply than demand, prices rise. The cost of money will rise, and thus the interest paid to borrow will rise as well.

So where does that leave the beggared citizens? With trillions less in entitlements and funds available for war, space travel, energy grids, education, etc. etc. The decline in government funds available for spending on entitlements is inevitable for purely demographic reasons; in the long view, a slow erosion in "lifestyle" and standard of living is also inevitable.

When will the decline trigger some sort of revolution? Only when the unsustainability of the present model of "cut taxes and borrow and spend" runs aground on the shoals of insolvency and bankruptcy. When the government can no longer pay its bills or borrow enough to do so, then the citizenry will face a revolution whether they want one or not.

It need not be a violent revolution, but it will be a revolutionary change in expectations and goals. The current goal (unstated due to denial) is to game the system to extract as much as you can as an individual; this impoverishing ethic will no longer work because the trough will be empty.

Tuesday, August 26, 2008

This Week's Theme: The Next Revolution The Moral Center of Revolution Every revolution has a moral dilemma at its center. Put another way, every revolution seeks to resolve a moral contradiction at the heart of the society. Chairman Mao famously said, "political power comes from the barrel of a gun," but what motivates people to pick up a gun, pitchfork or cobblestone after decades of enduring oppression and misery is not so easily described.

It appears rising food prices--and the hunger they cause--can pull the trigger on an explosive setting in a fragile, devolving nation-state. Historian David Hackett Fischer pointed out in his masterful work The Great Wave: Price Revolutions and the Rhythm of History (recommended to me by reader Cheryl A.) that the price of bread in Paris peaked on the very day a crowd spontaneously arose and tore down the Bastille prison stone by stone.

While it is interesting and important that price peaks correlate to political turmoil and transformation, clearly the moral contradictions at the heart of Royalist France were glaring and growing--contradictions which set the charge, so to speak, for some financial crisis to light the fuse.

Not every financial panic or price spike triggers a political and social revolution; the conditions and contradictions must have reached some unstable perfection of readiness.

This is likely to be wrenching because rising energy consumption has been a hallmark of "growth" and prosperity. While it is certainly possible to do more with less, that sort of quantum step up in efficiency requires massive inputs of energy, innovation, and labor.

Demographically speaking, our entire retirement (Social Security) and elderly healthcare models (Medicare) were founded on the premise that a ratio of 10 workers for every retiree would be an enduring feature of the economy. Alas, the ratio has shrunk to 3-to-1 even as the costs of healthcare and the number of elderly have both exploded far beyond what the planners of 1933 and the policy wonks of 1965 expected.

Yesterday I mentioned the political obstacle to any viable solution: when the number of voters receiving benefits exceeds the number of voters who are paying taxes but not (yet) receiving benefits, then any reduction in entitlements will be stymied. This is the moral dilemma at the heart of the coming era of turmoil/crisis: will the current generation (the Baby Boom) make the necessary sacrifices to right the bankrupt ship of government finance or will they cling to a debt-based demand for "what was promised to me"?

The U.S. is not alone in facing this demographic challenge. Correspondent Isabelle Q. in France sent in this highly relevant report on how France is addressing the impossibility of funding "what was promised to me":Somebody belonging to an ethical committee recently said : "« L’individualisme a vécu (…) Nos ressources n’étant pas illimitées, il faut essayer de les répartir de façon plus rationnelle. Aujourd’hui on est bien obligé d’admettre que si la santé n’a pas de prix elle a un coût. Et les médecins doivent désormais tenir compte du prix des médicaments dans leur décision. Notre vision va devenir sacrificielle : il vaut mieux correctement prendre en charge un père de famille de 40 ans, qui est rentable pour la société qu’une personne de 80 ans qui n’a pas toute sa tête ».""Individualism is over (…) Our resources not being unlimited, it is necessary to try to distribute them in a more rational way. Today we are obliged to admit that if health has no price, it has a cost. And doctors henceforth have to take into account the price of medicines/drugs in their decision. Our vision is going to become sacrificial: it is better to take correct care of a 40-year-old head of family who is profitable for society than take care of a 80-year-old person who no longer has all of his/her mind".

Here in France, doctors are going to do what they are told because their retirement will have to be complemented by the State in a few years.

One anecdote : a Baby Boomer I know, after having drunk too much and taken too much cocaine (coke), had to undergo a liver transplant. Quite expensive for society, he paid nothing. Well, after getting better he immediately looked for a way to cheat on his taxes and found one! After a while, necrosis attacked his new liver. And he began to have the jitters because he was afraid Social Security would not pay for a new transplantation after he turned sixty...

This report rather keenly illustrates the two moral issues at the heart of the coming financial crisis/bankruptcy of State promises: the need for "triage" (prioritizing healthcare) we have avoided by borrowing trillions, and the incentives for individuals to "game the system" for their own benefit.

If you know Medicare has ceased to exist and no one will pay for a new heart valve, defibrillator, hip, knee, etc. for you, what will be your response? I can't say what most people's response will be, but mine will be to start saving up cash and researching which hospitals in India, China, Thailand and Mexico have the lowest cost and best safety record for the surgery I may need. And I would do what I could to forestall surgery via diet, exercise, etc.

In point of fact I am preparing to receive none of the entitlements "I paid taxes for" and none of "what was promised to me." Reality has changed, so let's face it straight up instead of forcing insolvency on the nation.

The unnamed ethics committee member phrased the solution very well: Our vision is going to become sacrificial. The generation which came of age in World War II will be gone by 2020, and thus it falls to the Baby Boom generation to either shoulder the responsibility and forego "what I was promised" or cling to what is not affordable and drive the nation to bankruptcy--at which point this generation will most certainly not receive "what was promised to me."There are no promises or security in life, there is only reality and opportunity.

Bonus Mini-Essay on Military Spending/Waste

Several readers (Paul T.'s thought-provoking essay is linked below) challenged the position that U.S. military ("Defense") spending was less than social entitlement spending. Clearly, the wars in Iraq and Afghanistan are largely hidden "off-budget" in a sleight-of-hand which fools no one.But let's cut to the chase, shall we? The only way "cutting the Pentagon" will change anything is if you eliminate the U.S. Military entirely. Come on, folks--cutting $100 billion or even $200 billion out of a minimum $500 billion deficit--and more realistically, a $1 trillion deficit when all the bailouts of "too big to fail" firms are added in--is chump change. Trimming the military budget and exiting Iraq (which appears to be in progress) does not resolve the entitlements problem.

As I have covered here ad nauseum, Medicare alone is growing at a pace which will soon exceed the Pentagon's stupendous spending--and then keep on growing. There is no "Medicare Trust Fund," folks--it's paid out of tax revenues. Even if we "fix" Social Security's coming insolvency, Medicare alone will bankrupt the nation.

If you believe diplomacy can resolve every conflict, then consistency requires you abolish the U.S. Military except for the Coast Guard. I have no problem with that position, as long as the believers accept the consequences of not having a military when diplomacy fails to work its "soft power" magic. If you're ready to accept the consequences, then fine--at least that position is internally consistent and based on principles.

What I object to is a half-assed Military which places the citizens who volunteered to serve at greater risk due to crappy second-rate equipment, training and support. In other words, either don't have a military, or provide its personnel with the best you can get. We tried the crappy second-rate equipment routine before World War II, and as a result thousands lost their lives due to inadequate equipment, tactics, etc. Those of you who know your history know the drill--torpedoes that didn't expode, tanks that blew up, aircraft that were sitting ducks for Japanese Zeroes, 50% loss rates in bomber squadrons, and so on.

"Cut the Military budget" sure sounds easy--especially if you're not the one who's supposed to trust your life flying the cut-rate aircraft, etc. OK, fair enough--go over the budget yourself and see where the money goes. Dig deep. Hmm, mostly people costs, just like any other "business" in the U.S. How about those weapons systems the Pentagon wanted to cancel but Congress funded anyway, to lard some "pork" spending on their districts? How about the Naval facilities in West Virginia (no offense to residents of West Virginia, but the sea is not exactly nearby), placed there by a "liberal" (and powerful) congressperson?

How about all the other make-work/waste-money requirements stuck on by Congress? A significant percentage of Pentagon "waste" was intentionally put there by Congress as "pork" spending.

And let's not forget that it's civilians who send the Military off to war. I personally believe not one active-duty person should move an inch unless Congress formally declares war: no more of these half-assed "resolutions" which empower the President to wage open war without a declaration of war and without any sacrifices from the civilian populace at large.

OK, let's dig into that Pentagon budget. What do you want to cut, other than the Iraq war? New generation of nuclear weapons? Fine. That'll save a few tens of billions--about a week or two of Medicare's tab. How about the DDX destroyer? Well, what with labor costs being a big part of the Pentagon budget, the idea behind the DDX is to shrink the crew size drastically--I mean by half or even two-thirds. Over the 40-year life of a ship, that adds up to quite a substantial savings.

Hmm. Well, how about that tanker fleet we keep hearing about? Fine, but then you might as well get rid of the fighters and bombers, too, and in fact all aircraft, because they need to refuel in the air.

I find the "just cut the Military budget" line tiresome because it is based on a level of ignorance which would be unacceptable if applied to any other central responsibility of our government. Prioritizing is a constant process in Congressional committees and the services, and there have been good-faith efforts to reform pentagon budgeting for several decades now, for instance the Goldwater-Nichols ACt of 1986. The deeper you dig, the more "waste" can be traced directly to civilians, not the Military.

Meanwhile, academic studies have found that about 50% of Medicare spending is waste and fraud--and yet where are the pundits calling for Medicare funding to be cut in half? The reason there are so few voices calling for the eviceration of Medicare's stupendous waste is that everyone's hoping to tap the system for their own benefit.

In other words, let's be brutually honest: we're all for "cutting Pentagon waste" because so few of us are directly impacted. But cutting Medicare would require making very tough triage decisions which will very likely impact our own so-very-valuable selves. So that 50% waste--some $3 trillion a decade--is left untouched.

Which brings up another sore topic: the widening gap between those who serve in the Military and those who have little understanding of the Military, i.e. the average congressperson and citizen. I am not saying everyone should serve, only that we who did not should at least make an effort to understand that the Pentagon budget is not made and spent on some distant planet--it directly impacts those who serve in every way and every day. It's not just some line item.

I was a conscientious objector, and would have served in that capacity had the draft called me up. My stepfather was career Air Force. What joined us was that we each acted on our core beliefs. My sense of those who carp about "Pentagon waste" is that ultimately they'd rather not get involved with anything messy like actually understanding the Pentagon budget, demanding accountability from the civilian and military leaders or finding out what all those "easy cuts" would do to people who volunteered.

Yes, there is Pentagon contractor fraud and waste, and Congressional pork aplenty in the Pentagon budget, and billions in supplies lost and tossed due to lack of oversight, poor planning and fraud. The sums of money wasted in Iraq beggar the imagination. But where is the citizenry in all this? Everyone's too busy to care, it seems.

When the money runs out and we can't keep borrowing trillions from our international "friends," and an ever-larger sum is spent on interest paid to the trillions we so breezily borrowed during our false "guns and butter debt-based prosperity," then we'll have to start caring and have to get involved in the messy political business of prioritizing government spending, demanding accountability and healthcare triage. The sooner we start, the better off we'll be.

New must-read Readers Journals essay by Chris Sullins and Paul T.: Dust and Shadow (part 1 of his tour of duty in Iraq)

I mentally went through all my gear I had just prepared. I was wearing part of it which included body armor with front and back ceramic plates, helmet, ballistic goggles lifted over the front lip of the helmet, a holstered pistol with spare mags, a Mossberg shotgun dangled by its sling from a carabiner clipped on my right shoulder strap, and pouches holding shotgun shells nested firmly to my front.

If we somehow got separated from the convoy or ended up on foot the most important piece of gear, my GPS unit, was also in a pouch. Sergeant H stood nearby checking out the gear of the two young specialists we were rotating in for their first mission outside the wire. It was 0400 and we would be lining up for the convoy at 0500. This moment in my memory was from sometime early in my deployment. It held great anticipation for me at the time. Now when I wake up at the same time I look back at it and wonder to myself “WTF was I thinking.”

Well, I disagree with some of your discussion in "The Next Revolution". You will note that many prosperous OECD countries have a much higher safety net of benefits for the lowest quintile of their citizens than does the USA, so that has to raise some questions regarding what this country can afford. I believe that you were much more on the money on an earlier essay that opined that the US was horribly mis-managed.

Housing Bubble Bust Will Take Down the Global Economy (May 8, 2006)And what's happening now? The U.S. housing market is taking down the global economy. You read it here first. (Or perhaps second.) All of the trends analyzed above three years ago are still unfolding, and some are still "stealth" issues largely ignored by the MSM: for instance, the coming implosion of the Chinese real estate market, which is still in its very preliminary stages.

Which brings us to revolution. Do a search for "the next American Revolution" and you find thousands of entries on everything from the Minuteman Project to nanotechnology. In other words, in the usual erosion of powerful words to insipid pap, "revolution" now refers to anything and everything: nanotechnology, border security, the same old Chevy trucks "branded" by a "new" slogan, and so on.

As I have noted here before, there is startling evidence in the book The Fourth Turning ( recommended by astute reader Matt S.) that U.S. history follows a 4-generation/80-year cycle.

This is remarkably in line with the long cycles described in Terence Parker's prescient and concise work, The Rhythm of War.

The convulsive changes coming due around 2021 will not be centered around Chevy trucks, border patrols or nanotechnology. Before we get to what will be playing out in 2021, let's take a gimlet-eyed look at the First American Revolution.

Scrape all the patriotic gloss away and five key facts dominate the American Revolution:

1. Less than half the population of the American colonies supported the Revolution, and a large percentage actively supported the Royalist cause.

2. The American south was controlled by British forces until a small-scale brilliant military campaign led by Nathanael Greene and Daniel Morgan turned the tide at The Battle of Cowpens (The National Park Service).

The Southern Campaign, especially in the backcountry, was essentially a civil war as the colonial population split between Patriot and Loyalist. Conflict came, often pitting neighbor against neighbor and re-igniting old feuds and animosities. Those of both sides organized militia, often engaging each other. The countryside was devastated, and raids and reprisals were the order of the day.

The battle was over in an hour. It was a complete victory for the Patriot force. British losses were staggering: 110 dead, over 200 wounded and 500 captured. Morgan lost only 12 killed and 60 wounded, a count he received from those reporting directly to him.

At Cowpens, Daniel Morgan worried about obtaining food for his men - the area around the Pacolet River had been plundered and fought over so much, there was little to requisition. In addition, he had horses to feed. Each militiaman had brought a horse, in addition to those of the cavalry, making the total over 450. Perhaps that was part of Morgan's plan to stop at Cowpens - there should be some grass for the horses, even in winter, and, possibly free-ranging calves could be found and killed for beef. Beef was indeed available: James Turner, a Spartanburg District resident and participant in the battle, butchered beef to feed Morgan's army before and after the battle. It was reported that militia groups constantly left camp to hunt for forage. Such were the realities of feeding the armies.

3. The revolution was essentially bankrupt from the start, printing worthless money and struggling to feed its ragtag army.

4. Superior leadership at key points enabled a few thousand insurrectionists/ rebels /"patriots" to cling on against the superior forces of a rising Empire.

5. Victory was entirely dependent on the military power projection of a Great Power: France.

Those of you not terribly interested in the fleets of the 18th century may well be at a loss to understand just how stupendous a commitment it was for France to send a main battle fleet to cut off and starve into surrender the British Army at Yorktown.

These huge ships were constructed entirely by hand of wood, and carried immense firepower--74+ cannon. They required crews of hundreds of men, and were able to ferry entire armies across vast distances. They were the 17th century's super-weapons of "power projection," and they required not just stupendous national treasure but institutional and logistical skills far beyond the reach of all but a few Great Powers (English, French, Dutch, Spanish).

I have posted links to the great Chinese fleets led by Admiral Zheng He circa 1405-1419. He's fleet was basically a diplomatic/trade/influence mission, not a war fleet, and it was much larger than the European war fleets: an estimated 300 vessels, with some treasure ships of immense size. But these fleets did not have even a fraction of the firepower of the 16th-18th century European fleets, in which each ship's broadside unleashed up to 50 cannons of concentrated fire. A single broadside if properly aimed could devastate even the largest wooden-hulled vessels.

Being built of wood, rope and cloth sails, the ships were in constant need of maintenance and repair, and the struggle to provision the crew was never-ending. An excellent description of this struggle to maintain and provision a fleet--and keep morale up--can be found in this engaging biography of Admiral Nelson, The Pursuit of Victory: The Life and Achievement of Horatio Nelson.

The U.S. Continental Navy consisted of a few small ships. The French fleet at Yorktown was the equivalent of 6 modern U.S. Navy carrier groups--overwhelming naval superiority which even the British could not match in that circumstance.

The wily Ben Franklin's wining and dining and cajoling of the French leadership--and their own self-interest in nipping the British Lion's tail, of course--led to France's immense commitment of its treasure and super-weapon--the main battle fleet-- which provided the decisive victory which the rebels could never have won on their own.

I mention all this to show the American Revolution was a catch-as-can affair, a shoestring operation of survival against a far superior colonial power until a rival Great Power committed its immense military might to the rebel cause.

Was the revolution's success Destiny or just plain luck? For most of the long war (1776-1781), the rebellion clung on very precariously: bankrupt, riven by bitter disagreements, etc.It's important to recall that history only seems to have a clear narrative after the fact. In the moment, confusion, bitter conflict and contingency reign supreme. We should expect no less in the coming era of turmoil, dissolution and crisis, 2008-2021.

The next U.S. revolution was the Civil War, a complex playing out of conflicts and internal contradictions left unresolved in the compromises of the Continental Congress.

As the writing of history proceeds, various aspects of the Civil War gain or lose visibility. It was fashionable for a time to underplay slavery as a driving issue, and to focus on states-rights versus Federalism as the main point of contention. Focusing on Lincoln's political use of slavery lends creedence to this point of view, but it ignores the far more powerful forces at work in the minds of those actually fighting in the Union Army: the moral sin of slavery in terms of Christianity.

To underestimate the religious motivations of the war is to miss the single key driver in the minds of Union Army volunteers. You can bet the soldiers of the 20th Maine did not join to fight for Federalism or some other vague concept; they joined to "save the Union" and eliminate the key moral contradiction left over from the Revolution: slavery. Protestant Christianity essentially demanded the end of slavery, and all the arguments of southern theologians were contradictory and narrow, based heavily on Old Testament references to slavery rather than the New Testament of Jesus' teachings.

Undoubtedly slavery would have ended eventually, but the economy of the South was so inextricably dependent on slavery that its demise would have been wrenching regardless of the timing.

The other key driver of the Civil War which is largely ignored is immigration. If you study the financial records of slavery, you discover that slaves were not cheap: they cost a small fortune. The average soldier in the Confederate Army had as many slaves as he had mansions: none. They were too costly. The entire edifice of slavery was a high-cost system.

So why did the South cling so desperately to such a high-cost, morally pernicious and cruel system of forced labor?

The answer lies in the town squares of innumerable small town in the north, from Iowa to Pennsylvania: the statues and plaques honoring the Union volunteers, so very often drawn from recent immigrant stock. Immigrants were not drawn to labor on plantations of poor soil owned by a tiny elite; they were drawn to the promise of their own farms in rich valleys, and the promise of making a living by trade and manufacture.

The South was once the dominant population and economic force of the new nation, but by 1860 immigration, Yankee clipper ships and trade, and nascent manufacturing had transformed the North into the dominant region.

I should mention that my own family has deep roots in the South: Kentucky, Arkansas, and New Orleans, where the Bassets immigrated from French Canada. My niece's father was African-American, born in Cincinnati but his family reached back to North Carolina.

The Smiths, Maxwells and Wallaces trace back to Scotland, Ireland and England, and all came first to New England before setting off West. My stepmom's family came from Northern Mexico, and my wife's grandmother was a 1920s "picture bride" from Asia.

Thus does immigration grow the American family.

The next revolution was triggered by a gauntlet thrown down: either heel to Fascism or Totalitarianism or rise to global dominance and destroy the twin evils. The short answer is "World War Two" which transformed American life and power on a scale heretofore unseen.

And the next revolution? Many foresee Imperial over-reach; They have a valid point but if you "follow the money" (i.e. glance at the Federal budget) then you have to conclude the global military which enables U.S. power projection and influence costs far, far less than the sum we spend on elderly citizens via Medicare and Social Security. It is not debatable, it is fact: United States federal budget, 2008:Defense/military: $549 billionMedicare and Social Security: $1,142 billion

You can argue that we spend too much on our military, but you can't argue that supporting a military which costs 4% of GDP and 19% of Federal expenditures and less than 10% of all government expenditures is bankrupting the Empire.

What will bankrupt the Empire is social welfare entitlement spending which is heavily skewed to the elderly. We as a nation spend a relatively paltry sum on the children of the nation in comparison to what we spend on the elderly.

Before you launch the screeds and defenses of the status quo, please note I am months away from being a "senior citizen" (55) and a few years away from sucking up my share of all those juicy entitlements.

My hope is the nation declares bankruptcy before I draw a dime, in order to save our children and grandchildren from the crushing debt we elders have borrowed to fund our own spending on ourselves.

I know this isn't a popular view, and the reason it isn't popular is that tens of millions of voters draw checks and benefits from the Federal government. The U.S. is now like France: the number of people drawing money from the government exceeds the number who pay taxes but receive no personal benefits (i.e. no disbursement or direct benefit like medical care). With recipients in the voting majority, they will never vote to cut their own entitlements. Thus we are doomed to borrow and spend until bankruptcy forces an end to the Empire of Debt.

Make no mistake: the $9 trillion we've borrowed wasn't devoted to military might except for a brief period during World War Two. It has been spent on social entitlements enjoyed by tens of millions of citizens. We can debate the ethical value of this spending until the day bankruptcy is declared; that the elderly deserve some support in their declining years is beyond question, just as the education and feeding of our children is beyond question, for future generations are the entire future of the nation.

The next revolution will most certainly have a financial catastrophe, a demographic train wreck and a deep moral bankruptcy at its core. Profligacy has a price, and we are doomed to cling to generationally selfish spending until our financial house of debt-cards finally collapses, taking all the generational Ponzi schemes and entitlements with it.

New must-read Readers Journal essay by Chris Sullins:Dust and Shadow (part 1 of his tour of duty in Iraq)

I mentally went through all my gear I had just prepared. I was wearing part of it which included body armor with front and back ceramic plates, helmet, ballistic goggles lifted over the front lip of the helmet, a holstered pistol with spare mags, a Mossberg shotgun dangled by its sling from a carabiner clipped on my right shoulder strap, and pouches holding shotgun shells nested firmly to my front.

If we somehow got separated from the convoy or ended up on foot the most important piece of gear, my GPS unit, was also in a pouch. Sergeant H stood nearby checking out the gear of the two young specialists we were rotating in for their first mission outside the wire. It was 0400 and we would be lining up for the convoy at 0500. This moment in my memory was from sometime early in my deployment. It held great anticipation for me at the time. Now when I wake up at the same time I look back at it and wonder to myself “WTF was I thinking.”

Friday, August 22, 2008

Income Inequality in the U.S. Correspondent Anne S. responded to Saved by U.S. Savings? Don't Count On It (August 20, 2008) with this wide-ranging commentary on rising income inequality in the U.S. Anne touches on many large, complex drivers such as healthcare and education which are often ignored in the "ideology wars" over income distribution (Right= re-distribution: bad, Left=re-distribution: good):

As Charles points out, we should always remember distribution of wealth or income. Averages can be very misleading. Massive research attests to the fact that financial inequality has grown in the US in the past 30 or so years. Naturally enough, other inequalities follow. The pattern of inequality may be different in different places, various social strata, groups, etc. However, let's set that aside, or leave it hanging, and consider the overall rising slopes of the costs of things in the US as presented in the entry, CPI 1978-2004.

Are the changing costs related to rising use, consumption, benefits, bonuses, gains of some kind?The rise in educational attainment is respectable. For 1970-2007, the % of Whites with 4 or more years of college passed from 11 to 31; for Blacks 6 to 18. (1)

For health care, balancing gains and advances with losses, regressions for 1975-2005 is hazardous. Many US health stats have sunk in this period; and new, better treatments have emerged. Health is tricky, as it is linked not only to care but to life-style, nutrition, the work place, epidemics, climate, etc. Using country comparisons, it appears that health care in the US is the most expensive in the world, and in terms of performance or outcome ranks extremely low, often bottom when compared to other OECD countries.

Possibly: health care costs in the US today could be cut by a third for the same, or possibly even a better, result. The rise in cost from 1978 has not been accompanied by strong, demonstrable, consequent 'better health' overall (beware of social change, ceiling effects, shoddy indicators, AIDs, etc.)

In these areas, with their truly rising costs, intangibles like knowledge and well-being created by human activity are sold. The use of resources is not too extravagant - classrooms, operating theaters, pills...It is the rise of the 'knowledge economy' or in other terms the institutionalization of a cadre class through education and 'merit', often inherited through wealth and status, which itself acts like a positive feedback loop: more expertise = more knowledge = more education = higher pay = more cost... > more education, > higher costs, etc. Once such mechanisms get going, a coterie of servants, middlemen, bureaucrats and profiteers shows up. Health insurers and banks (student loans) come to mind.

Higher education and health represent a larger, expanding slice of family budgets. The outlay is often perceived as unavoidable, obligatory, and in the top mid to upper classes, worth saving for, or marrying for, or cheating for, or, going into debt for...

Yet, with overall 'ordinary' budgets strapped or maxed out, both areas now are subject to uncertainty in decision making, investment, and increased risk (failure, sudden illness, etc.) To save, one needs to be in an environment which has a certain stability, where decisions can be tied to future expectations, and where saving is perceived as rational and useful.

For food, cars and transport, the picture is different. In some constant measure, or as % of family expenditure, very roughly here, in the past 40 years, costs have sunk, stayed similar, or risen somewhat. Americans have used, consumed more per capita (cars, planes, roads, food), done so with more comfort, splash, gadgets and/or efficiency (e.g. cars, take-out) - the extra cost, if any, seems well accounted for. Food is somewhat particular: Americans *have* eaten more (see (2) for the rise, probably underestimated, of consumption in all food groups except dairy - 1970-2006) but the quality of food has deteriorated and overeating has had negative impact on health for those not in the dominant class.1. Educational Attainment by Race and Hispanic Origin, 1940–20072. The Overflowing American Dinner Plate (chart, NY Times)

Thank you, Anne, for this thoughtful, nuanced commentary. There are many subtle threads in Anne's comments; I will mention a few that struck me (and of course I will undoubtedly miss many others).

I think Anne is describing the growth of a "new elite" which feeds off the institutional/bureaucratic fiefdoms of healthcare and education which have largely escaped global competition.

She is also pointing out that some increased consumption--for example, more fatty foods and more meat--may well have been detrimental to the populace, running counter to the Standard Ideology that "more consumption is always better."

As she notes, people whose parents have college degrees are statistically much more likely to obtain higher-education degrees. Though the system remains "merit-based," the reality is that inherited wealth and status (as defined by higher education, income, healthcare, etc.) do play a major predictive role. Nonetheless, mimorities in the U.S. have made great strides in terms of higher education (see link above).

To me, these are key points: "Intangibles like knowledge and well-being created by human activity are sold; higher education and health represent a larger, expanding slice of family budgets."

In other words, manufactured goods like TVs and computers have plummeted in cost in terms of purchasing power as China and Asia's emergence as low-cost manufacturers has lowered the cost of virtually all goods which can be shipped, while "services" like healthcare and education which cannot be shipped have risen steeply and inexorably.

While "medical tourism" to India, Thailand and Mexico is rising--i.e. going abroad to obtain heart surgery for 10-20% of the cost of the operation in the U.S.-- global competition is still a small influence on the institutional fiefdoms of healthcare and education.

What I note is that the cost structures of these fiefdoms have few meaningful constraints imposed by competition. Anne touches on one reason: as "merit" and "status" play roles in gaining admission into the "new elite" of these well-funded, protected fiefdoms, then the middle classes (low, median and upper) perceive some relative competitive advantages to getting their kids into Ivy League or high-status private/public universities.

At the same time, rising expectations for a long, healthy life are running up against an ever-rising healthcare cost structure and a pernicious cycle of declining well-being due to excess consumption and "lifestyle" diseases. Beyond a certain point, the more you eat, the lower your well-being. Endless "entertainment" (watch 8 NFL games on one screen! I actually saw that guaranteed insanity-inducing "excess" hyped on commercials during the Olympics) has enabled a "couch potato" lifestyle with all the attendent chronic diseases.

I wonder how much fear plays a part in this seemingly desperate battle to squeeze into the ranks of the "new elite" living off the competitive-free fiefdoms. If you fear you won't measure up, then what's your response? Find some "protected" enclave--an enclave protected by legislated fiat (tariffs, subsidies, etc.) or by barriers to global wage arbitrage and global competition.I have long suggested that the only real driver for lowering the cost structure of healthcare in the U.S. will be 100+ major state-of-the-art hospitals across the border in Mexico which cater exclusively to Americans with cash, clinics which provide the same level of care for 25%-30% of the cost of the care in the U.S.

The choice for U.S. healthcare will then be, adapt or die. Creative destruction is the core of capitalism. Fear-based moat-building and the garrisoning of fiefdoms protected from global competition can only stave off the destructive forces of bloated cost structures and inequality for so long.

So much of the "growing inequality" debate is cast into the ring of taxes and income re-distribution via "tax the rich and give entitlements to everyone else." But that ring is simply too small to account for the deep cultural and economic forces at work on macro scales and generational timelines.

More on oil and demand destruction: Frequent contributor U. Doran sent in this well-researched article on "demand destruction" for oil in the U.S.: Oil Demand Destruction & Brittle Systems which plays into my thesis presented yesterday that the vast majority of demand is inelastic and not subject to huge declines:

I've seen a number of comments, both at TheOilDrum and elsewhere, suggesting that the US is now less susceptible to supply disruptions because we have reduced our demand for oil by several hundred thousand barrels per day over the past year.

In general, I get the sense that people think we can insulate ourselves from supply disruptions, from our dependence on potentially unreliable foreign sources of oil, by improving our efficiency and eliminating "unnecessary" oil consumption.

In my opinion, this is backward. In this post, I will argue that, because the demand that is destroyed first in a free market is the demand that is easiest to eliminate, the resulting consumptive system is more inelastic, more brittle, and more susceptible to systemic shock from supply disruption. I will approach this argument by outlining what makes a system either resilient or brittle and why market-driven demand destruction creates a more brittle system. I will conclude with a few thoughts on how we can increase the resiliency of our energy-driven economy in a future environment of declining energy supplies.

Thursday, August 21, 2008

Oil to $70/Barrel? Don't Count On It Now that "demand destruction" (people driving less, replacing SUVs with Priuses, etc.) is in the news, respected pundits are calling for $70/barrel oil. Don't count on it.

The "big news" is oil consumption has dropped in the U.S. by 700,000 barrels per day (BPD)--about 3.3% of the 21,000,000 BPD the U.S. consumed last year. Concurrent with this decline, the OPEC exporters boosted production, as shown by this chart (courtesy of theoildrum.com):

Frequent contributor U. Doran sent in this detailed report on global supply, which has country-by-country production charts: Oilwatch Monthly - (Netherlands) August 2008. Here is quote which describes one constraint on future supply increases: a shortgage of equipment and personnel:

Nevertheless, these production additions have proven to be insufficient for consumption to continue its onward path of increase. The production part of the equation prices can only do so much as there is material and personnel available for drilling. The latest global offshore rig order count now totals 165 for just the next three years, from a total existing amount of 584 offshore rigs. A huge increase in such a short space of time. To man those rigs and provide ground personnel approximately 16.500 new employees are needed in just the next few years. Already there is difficulty in acquiring new personnel. This new cycle of oil industry material buildup will therefore inherently be constrained by delays that are not about to ease.

Correspondent Mike D. sent in this story, which describes another constraint: "geopolitical peak oil," or the inability of the national oil companies (which control 87% of global production) to equal the global oil "supermajors" technical skills in finding and extracting deep oil and pulling more oil from depleting wells: As Oil Giants Lose Influence, Supply Drops (NY Times)

As late as the 1970s, Western corporations controlled well over half of the world’s oil production. These companies — Exxon Mobil, BP, Royal Dutch Shell, Chevron, ConocoPhillips, Total of France and Eni of Italy — now produce just 13 percent.

Arjun Murti, an energy analyst at Goldman Sachs:“What we have now is geopolitical peak oil.”

Western companies are far better than most national oil companies at finding and extracting petroleum, experts say. They have developed advanced exploration technologies and can muster significant financing to develop new fields. Many of the world’s exporting states, however, have spurned their expertise.

Oil company executives see a straightforward explanation: a trend known as resource nationalism. They contend that they have been shut out of promising regions by a rising assertiveness in the Middle East, in Russia, in South America and elsewhere by governments determined to keep full control of their oil."

If we look at a chart of global oil production, we see it's bouncing around a plateau since 2005--in other words, this is as good as it gets, production-wise:

In other words, exporters are pumping full out and supply has reached the upper limit of real-world capacity. As this chart reveals, OPEC's spare capacity has dwindled to a mere shadow of its former glory. The Saudis boosted production this year by 500,000 BPD and that appears to be about all they can manage in the real worlds, despite claims to the contrary.Here is poster "Rembrandt" from this TOD (the oil drum) link: Oilwatch Monthly - europe.theoildrum.com August 2008

Given that most of the incremental new conventional production comes from Saudi Arabia, and almost all from the middle-east, I wouldn't be too sure about this being a sustained uptrend. Especially given the production decreases in Saudi-Arabia /Middle-east that preceded this uptrend.

It also makes it unlikely that a large share is from 'new' production. The comments on The Oil Drum are generally very well-informed and I highly recommend reading the comments in the above link.

A number of other factors suggest supply will be falling in tandem with demand, keeping prices high. And by "prices" I mean in gold; if the dollar falls again, then oil will rise in cost since it's priced in dollars; if the dollar strengthens, oil will become nominally "cheaper" to those of us buying it in dollars.

But if demand falls by 5 MBD (million barrels a day) and supply falls by 6 MBD, then prices will continue to rise.

One of the TOD comments reported that the Saudis are pumping 6 million gallons of water into their supergiant oil fields every day to maintain output of 4 MBD. The source said this pressure will keep production aloft until the water rises to the pumps--at that point production doesn't decline, it basically falls to zero very abruptly. Boom, the world loses 5% of its oil supply.

You can quibble about new production coming online and a thousand other details about global oil, but the fact is we consumers still rely on a handful of depleting supergiant fields for about half of all the oil we consume. The fields in the North Sea, Mexico, Russia and the Mid-East are in decline, and are requiring ever-more expensive recovery techniques to maintain production.It is not at all unlikely that global production could fall 8-10 MBD, or basically drop back to 2002 levels. If demand also falls by 10% globally, then no harm, no foul-- prices remain in equilibrium. But if demand falls by less than supply, prices could rise despite global recession.

Another factor is the Export Land Model which reflects the skyrocketing demand within oil exporting nations. As their domestic demand skyrockets due to subsidies and domestic needs (remember the 1 million barrels a day the Saudis plan to burn to generate fresh water in quantity), the amount of oil available for export plummets.

Lastly, we need to be realistic about just how inelastic demand for oil is in the U.S. and much of the world. There is no alternative, and a global recession is not the best time to be expecting tens of millions of consumers to go out and buy new vehicles. Recall that there are 230 million vehicles in the U.S. alone.

Recall that "alternatives" currently account for a tiny sliver of total energy: less than 2 million barrels of biofuels out of 85 million barrels of oil a day, and wind/solar/geothermal etc. produce perhaps 3% of total global energy.

Nonetheless I have long expected a "head fake" in which demand falls rapidly enough to fall briefly below supply, causing a sharp downward spike in price. The question now: was the drop from $147 to $112/barrel the head-fake, or is this just the first leg down in a more prolonged head-fake which drops the price to $90?

One of the TOD commentators noted that the tax structure in Russia guarantees that once oil falls to $90/barrel, the producers earn basically zero--the taxes eat up all profits. So we should also be aware of the tremendous forces within exporters to lower supply in order to keep prices "high."

How high? here's a chart which depicts oil as a percentage of global GDP.

From the exporters' point of view, the world managed to spend 7% of GDP on oil, why not keep it at 7-8%?For every household in the U.S. which buys a hybrid and saves a few gallons of gasoline a week, there is a Chinese household which buys a new car--a car they probably won't drive much. Thus they can afford a little gasoline even at $5-$10/gallon.

There are also new motorscooter owners in Asia who only need a few liters of fuel to operate their business, and they will pay whatever the cost might be, as they need it to make a living and the quantity of fuel required is small. In other words, it's high-consumption Americans who will feel real pain at $8-$10/gallon; much of the rest of the world will do just fine because they use so much less per capita.

That's another reason to doubt a massive drop in global consumption.

Here's my previous charts of the "head-fake" and a chart I posted in March illustrating the probable climb in oil prices as the excuses that all price increases are the result of "speculators". If only it was that easy; it may well be that this "head-fake" has already run its course, setting up the next rise in price which then triggers another "head-fake" which lowers prices until supply again falls below demand.

Maybe algae-based biofuels can be scaled up to 100 million barrels a day, but it's unlikely to come online fast enough to replace oil in the next few years/decade. Maybe I'm wrong and alt. energy will scale up more rapidly than many of us expected; but that will require literally trillions of dollars of investment, right at the point that credit and capital are in deflationary spirals downward. Where to get the trillions? That is a key question I have raised before. Now that we spent all our surplus capital/earnings (as a nation) on interest on new debt, BBQ grills and granite countertops, 2nd homes we don't need, MRIs, drugs that don't work, lavish public pensions, stealth aircraft and a host of costly wars and boondoggles, then there isn't any left for funding an entirely new energy complex.

Wednesday, August 20, 2008

Saved by U.S. Savings? Don't Count On It The new happy talk goes like this: Americans are getting thrifty, paying down debt and saving money. Interest rates will drop because they're going to dump all their savings into safe U.S. Treasury bonds. Once they've lowered their non-mortgage debt payments to 10% of income from the current 14%, then this gloriously low-interest rate environment and these trillions in new savings will spark the next Bull Market cycle of growth--in, say, mid-2009.

Nice story, and I love the Hollywood ending. But is there any shred of reality in the fairy tale? It turns out academics have been struggling for the past 15 years to explain the declining U.S. savings rate, which dropped into negative territory in 2006 and 2007. The number of causal agents in the U.S. economy is huge, so quite naturally there is no one academically vetted "answer." Nonetheless, there are a few theories which have gathered some constituencies.Let's start with a chart of the U.S. personal savings rate:

The happiest story is that Americans don't need to save anymore because the equity in their 401K stock market holdings and in their homes has skyrocketed, creating a huge pool of wealth. Well, at least that equity skyrocketed for awhile. Now that the bubbles in tech stocks and housing have popped, then Americans will start saving again. (i.e., we still get a happy ending despite bubbles popping.)

I submit that the underlying reason Americans' savings rate has been in decline for 25 years is that Americans' wages and incomes have been stagnating for 25 years even as their expectations rose to astonishing heights.

I also submit that the rising income inequality in the U.S. means that the top 10% of earners will indeed be saving, but the bottom 60% will have more in common with this couple:

Rising inequality of incomes is simply a fact, and whether this is a good thing or a bad thing or exactly why it is so is not my focus here. The point is that middle incomes have been squeezed for decades.This also shows why we have to be careful about drawing conclusions based on "savings rates" drawn from the entire population. If the top 10% of earners start saving 20% of their income while the bottom 60% save nothing, the savings rate for all Americans will be positive and cheery.Such a conclusion would be deceptive, to say the least.Before we completely rain on the Hollywood Happy Ending of thrifty Americans saving scads of cash and enabling a new Bull Market in 2009, let's look at a few charts for context:

And let's not forget that our "prosperity" of the past 25 years has been based on borrowing and spending trillions of dollars:

There's a few other flies in the ointment for the happy story about Americans savings trillions and sparking a new Bull Market.

Number one is Peak Oil--no, it did not go away because the U.S. cut its demand by a meager 3% and the Saudis pumped an extra 500,000 barrels a day--more on that tomorrow.Rising energy costs act as a huge tax on the economy and incomes.

Readers continue to ask me about inflation-deflation, and my answer is: you can't lump everything together and get an answer. 100+-year cycles of inflation and wage stagnation are driven by stupendous demographic forces of demand which outstrip supply of energy, food, etc. We are in such a period.

At the same time, vast global overcapacity in manufacturing insures that the cost of manufactured goods will not rise as fast as input costs (energy and commodities).Concurrent with these forces, we have asset deflation on a vast scale which will remove "the wealth effect" and actual buying power from everyone owning assets which are dropping in value/buying power (stocks, real estate, etc.)

Last but not least, we have government-mandated costs which are immune from global competition and wage arbitrage: public sector wages, medicare/healthcare costs, education, etc. All of this can be seen in the following chart:

Last but not least, let's recall that "personal income" includes dividends, interest and rental incomes--the "earnings" from owning capital. Since capital is highly concentrated in the U.S., so is this capital-derived income.

Personal saving -- disposable personal income less personal outlays -- was a negative $50.5 billion in the first quarter, compared with a negative $15.8 billion in the fourth. The personal saving rate -- saving as a percentage of disposable personal income -- decreased from a negative 0.2 percent in the fourth quarter to a negative 0.5 percent in the first.

Saving from current income may be near zero or negative when outlays are financed by borrowing (including borrowing financed through credit cards or home equity loans), by selling investments or other assets, or by using savings from previous periods.

Here is a paper from the St. Louis Fed on The Decline in the U.S. Personal Saving Rate. The point made here cannot be overstressed: so-called capital gains or increases in equity cannot actually be realized by everyone, because selling (to capture the gains) instantly sends markets plummeting, destroying the gains. Paper profits are indeed illusory, and everyone claiming they are the equivalent of savings is wrong.

Furthermore, it has been observed that a large portion of unrealized capital gains tends to arise in the presence of volatile "bubbling" conditions (e.g., the stock market boom of the late 1990s and the housing price surge of 2002-05); as such, these gains have to remain unrealized almost by definition—if households tried to cash them in, they would cause the bubble to burst, causing the capital gains to vanish.

Many readers have pointed to insurance companies and pension funds as buyers of T-bills and other U.S. debt. Undoubtedly they have been buyers, but rather clearly their buying is only a fraction of what's needed to fund most domestic borrowing with domestic savings. How do we know this? Because the U.S. has been relying on foreign funding while we borrowed and spent so carelessly:How Long Can The U.S. Count On Foreign Funding? (March 5 2007)

The Happy Story Fantasy of Americans saving enough to fund their own deficit spending requires that Americans save at least $1 trillion a year and devote every penny to Treasuries and muni bonds. To fund our mortgages, corporate paper and other borrowings: better save another trillion or two.

Next up, Fed Vice Chairman Roger W. Ferguson on why how household expectations of ever-increasing spending may be one culprit in the abysmal savings rate:

Remarks by Vice Chairman Roger W. Ferguson, Jr.Another explanation for the decline in the personal saving rate relates to possible upward revisions to households' expectations for their long-run or permanent income. Credit card usage has grown exponentially over the past two decades, and the ratio of consumer credit to income has increased 50 percent.

It is reasonable to expect that the saving rate of the top quintile of the income distribution will do the bulk of the rebounding. (emphasis added: CHS) As I noted earlier, the saving rate of this quintile accounted for virtually all of the decline in the aggregate personal saving rate. Because households in this income quintile own about 65 percent of aggregate net worth, any revaluation of assets will be felt strongly in this group and consequently their saving behavior should most clearly reflect this influence. So Mr. Ferguson is saying the 20% will be doing whatever saving will be done. Nice for them, but what about the other 80%? What he is also suggesting is that as we've collectively expected more and more income, we've compensated for the gap between reality (stagnant incomes and declining purchasing power) and our expectations ("I deserve it!") by borrowing off credit cards and our equity.

For more on typical households' financial decline, please read: Family Income Report.Let's run some numbers. According to the U.S. Census Bureau, the top 20% of households earn about 50% of all income. Since total personal income is $11.6 trillion, that gives the folks who are most able to save a total income of $5.8 trillion.

Let's say the Happy Story kicks in and these fortunate few (interestingly, the Pareto principle 80/20 rule appears to be in play here) start saving 8% of their income, i.e. a return to the pre-borrowing-binge rate.

That would yield a sum of $464 billion--roughly the current anticipated Federal deficit. Meaning: if the Happy Story comes true, then the top 20% better buy nothing but U.S. Treasuries.But what about all those municipal bonds? And what about all the Treasury debt that comes due and has to be rolled over? What about corporate bonds, and mortgages and all the other flavors of debt/borrowing in the U.S. economy?

If pundits like Mr. Bill Gross are correct, Federal deficits will zoom to $1 trillion next year as the bailouts and shrinking tax revenues collide with rising entitlements and war expenses. Add in the Treasury debt rollovers, state, county and agency bonds (muni bonds), corporate bonds and paper and new mortgages and you'd need about another $1 trillion a year in savings, for a total of $2 trillion.

So for the happy story to work out, the top 20% will have to save not 8% of their income but 34%--a staggering sum.

Even if all wage-earners managed to save 8% of their total incomes, that would create $928 billion in savings--perhaps half of the debt that public and private entities in the U.S. will issue next year.

Back in the real world, the other 80% will be struggling to keep up with rising energy, food, education and healthcare costs even as every level of government skims an ever-larger share of their income via junk fees, levies, and just flat-out higher taxes.

Clothing, houses, used SUVs and second-hand furniture will be cheaper--if anyone still wants to buy them.

Lastly, based on my own observations, Mr. Ferguson pinpointed something important: people's expectations have not yet declined to map reality. Back in the 60s, very few people ate out, regardless of their income. Fast-food outlets were rare. Even middle-class families rarely ate out (my father was a mid-level manager and I can count the number of times we bought anything away from home but hamburgers on one hand. This was typical, in my experience.)

Overseas travel was reserved for very high-income families or retirees who'd saved a lifetime.Now, every teenager feels it is his/her "right" to have a fast-food meal or costly drink/snack every single day. Millions of households consider exotic travel a standard feature of life. Ditto having your pet in a kennel during your vacation, having pet sitters and personal trainers, going to the gym, hiring a crew of housecleaners every month, having your oil changed, buying fancy prepared meals at the supermarket deli, store-bought haircuts for kids, and all the other accoutrements of "middle-class" life.

What few seem to recall is all of these services used to be performed by the household members or in the case of dog-sitting, neighbors or extended family. The general cultural zeitgeist in the U.S. is that doing such things for oneself is declasse, and besides, "we deserve it" or "we're too busy." Yet astoundingly, we collectively find time to watch TV 8 hours a day and spend other valuable hours texting, talking on the phone, surfing the Net, etc. Too busy, indeed.

The mismatch between expectations and reality has never been greater, except perhaps in 1928 just before the Great Depression--and I suspect we are far more out of touch with reality than the Roaring 20s denizens.

Saved by U.S. savers? Dream on, and gimme another hit of Euphorestra.

Oh, and there's one last fly in the happy-savings ointment: jobs are lost in recessions, and we're in the first inning of this recession. It is hard to save when your income is cut to unemployment benefits, and even harder when those run out.

New Book Notes: My new "little book of big ideas," Weblogs & New Media: Marketing in Crisis is now available on amazon.com. The price is currently listed at a default of $15, but I am working on getting it lowered to $10.99. Check back later in the week to order a copy at the lower price.

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